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Economics

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The study of how individuals and society use the scarce resources that nature and previous generations have provided.

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Microeconomics

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The branch of economics that examines the behavior of individual decision-making units - that is, business firms and households.

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Macroeconomics

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The branch of economics that examines the behavior of economic aggregates - output (GDP), unemployment, inflation - on a national scale.

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Positive economics

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Studies economic behavior without making judgements. It describes what exists and how it works.

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Normative economics

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Also called policy economics, analyzes outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action.

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Aggregate behavior

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Refers to the behavior of all households and firms together.

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Microeconomists

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Generally conclude that markets work well. Observe that some important prices often seem "sticky."

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Sticky prices

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Are prices that do not always adjust rapidly to maintain the equality between quantity supplied and quantity demanded.

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Great Depression

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A period of severe economic contraction and high unemployment that began in 1929 and continued throughout the 1930s.

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Classical economists

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Applied microeconomic models, or "market-clearing" models, to economy-wide problems.

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Market-clearing

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At the end, supply = demand.

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John Maynard Keynes

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1936 - published The General Theory of Employment, Interest, and Money. Believed governments could intervene in the economy and affect the level of output and employment. During periods of low private demand, the government can stimulate aggregate demand to lift the economy out of recession.

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Fine-tuning

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Used to find precise inflation rate and unemployment rate. Phrase used by Walter Heller to refer to the government's role in regulating inflation and unemployment. The use of Keynesian policy to fine-tune the economy in the 1960s, led to the disillusionment in the 1970s and the early 1980s.

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Stagflation

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Occurs when the overall price level rises rapidly (inflation) during periods of recession or high and persistent unemployment (stagnation).

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Aggregate output

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The main measure of how an economy is doing. The total quantity of goods and services produced (or supplied) in an economy in a given period.

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Business cycle

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The cycle of short-term ups and downs in the economy.

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NBER

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National Bureau of Economic Researchers.

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Recession

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A period during which aggregate output declines. Two consecutive quarters of decrease in output signal a recession.

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Depression

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A prolonged and deep recession.

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Great Recession

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Downturn of '09.

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Real GDP - Roaring 20s

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Referred to as the bubble, because it eventually pops.

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Expansion/Boom

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The period in the business cycle from a trough up to a peak, during which output, inflation and employment rise. (GDP rises, Unemploy. falls)

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Contraction/Recession/Slump

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Period in the business cycle from a peak down to a trough, dying which output, inflation and employment fall.

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Unemployment rate

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The percentage of the labor force that is unemployed. A key indicator of the economy's health. Seems to imply that the aggregate labor market is not in equilibrium. The ratio of the number of people unemployed to the total number of people in the labor force.

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Inflation

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An increase in the overall price level. Creates administrative costs and inefficiencies. Without inflation, time could be used more efficiently. Opportunity cost of holding cash is high during inflations. People therefore hold less cash and need to stop at the bank more often. People are not fully informed about price changes and may make mistakes that lead to a misallocation of resources. Higher inflation rates are also more variable, making them harder to anticipate. Once inflation becomes imbedded in expectations, it is much more difficult to control.

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Hyperinflation

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A period of very rapid increases in the overall price level. Rare, but have not been used to study the costs and consequences of even moderate inflation.

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Deflation

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A decrease in the overall price level. Prolonged periods of deflation can be just as damaging for the economy as sustained inflation.

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Fiscal policy

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Refers to government policies concerning taxes and spending. The manipulation of government spending and taxation.

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Monetary policy

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Consists of tools used by the Federal Reserve to control the quantity of money (and therefore interest rates) in the economy. Refers to the behavior of the Federal Reserve regarding the nation's money supply.

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Growth/supply-side policies (Reaganomics)

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Government policies that focus on stimulating aggregate supply instead of aggregate demand (aka "Reaganomics", supply-side economics). Decreasing corporate taxes and regulations thereby lowing production costs are examples.

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Goods-and-services market

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Households and government purchase goods and services (demand) from firms in the goods-and-services market, and firms supply to the goods-and-services market.

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Labor market

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In the labor market, firms and government purchase (demand) labor from households (supply). The total supply of labor in the economy depends on the sum of decisions made by households.

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Money market

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In the money market - sometimes called the financial market - households purchase stocks and bonds from firms. Households supply funds to this market in the expectation of earning income, and also demand (borrow) funds from this market. Firms, government, and the rest of the world also engage in borrowing and lending, coordinated by financial institutions. The market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined. Money demand = money supply (determines r) I depends on r (P.I.F.)

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Treasury bonds, notes, and bills

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Promissory notes issued by the federal government when it borrows money.

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Corporate bonds

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Promissory notes issued by corporations when they borrow money.

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Shares of stock

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Financial instruments that give to the holder a share in the firm's ownership and therefore in the right to share in the firm's profits.

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Dividends

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The portion of a corporation's profits that the firm pays out each period to its shareholders.

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Gross national product (GNP)

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The total market value of all final goods and services produced within a given period by factors of production owned by a country's citizens, regardless of where the output is produced.

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Gross domestic product (GDP)

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The total market value of all final goods and services produced within a given period by factors of production located within a country. New good or service must be produced to count. (labor capital) As of 1991 US joined most countries and uses GDP. (Every 3 months calculated)

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National income and product accounts (NIPA)

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Data has been collected and published by the Bureau of Economic Analysis (BEA), of the Department of Commerce ever since. It tracks in detail the various components of national income and output of the US economy.

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Expenditure approach

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One way of calculating GDP: A method of computing GDP that measure the goal amount spent on all final goods during a given period.

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Income approach

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One way of calculating GDP: A method of computing GDP that measure the income - wages, rents, interest, and profits - received by all factors of production in producing final goods.

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Personal consumption expenditures (C)

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Household spending on consumer goods.

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Gross private domestic investment (I)

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Spending by firms and households on new capital: plant, equipment, inventory, and new residential structures.

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Government consumption and gross investment (G)

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Counts expenditures by federal, state, and local governments for final goods and services.

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Net exports (EX - IM)

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Net spending by the rest of the world on goods produced in the US. The difference between exports and imports. The figure can be positive or negative.

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Expenditure approach equation

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GDP = C + I + G + (EX - IM).

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Durable goods (C)

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Goods that last a relatively long time, such as cars and appliances.

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Nondurable goods (C)

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Goods that are used up fairly quickly, such as food and clothing.

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Services (C)

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Things that do not involve he production of physical things, such as legal services, medical services, and education.

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Investment

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Refers to the purchase of new capital (equipment or facility). Sale of stock or bond would NOT count as it does not involve production of a new final good, only changes ownership of existing good. Sale of used equipment would not count, nor would the sale of a new part that gets purchased by a manufacturer of final goods, as it is a component of some other final good.

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Gross private domestic investment

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Total investment by the private sector. It includes the purchase of new housing, plants, equipment, and inventory by the private sector.

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Nonresidential investment

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Includes expenditures by firms for machines, tools, plants, and so on.

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Residential investment

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Includes expenditures by households and firms on new houses and apartment buildings.

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Change in inventories

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Computes the amount by which firms' inventories changes during a given period. Inventories are the goods that firms produce now but intend to seek later.

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GDP

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Not the market value of total sales during a period - it is the market value of total production. A firm produces new final goods/services it counts in GDP, even if they didn't sell the good to a final user. The un-purchased goods get added to "inventory". The relationship between total production and total sales is: GDP = final sales + change in business inventories.

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Exports (EX)

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Are sales to foreigners of U.S.-produced goods and services.

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Imports (IM)

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Are U.S. purchases of goods and services from abroad.

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National income

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The total income earned by the factors of production owned by a country's citizens

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Income approach

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To GDP breaks down GDP into four components: GDP = national income + depreciation + (indirect taxes - subsidies) + net factor payments to the rest of the world + other

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Personal saving rate

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The percentage of disposable personal income that is saved. If the personal savings rate is low, households are spending a large amount relative to their incomes; if it is high, households are being cautious and spending a smaller portion of their income - this commonly happens during recessions.

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Nominal GDP

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GDP measured in current dollars, or the current prices we pat for things. Includes all the components of GDP valued at their current prices. When a variable is measured in current dollars, we say it is in nominal terms. If you want to know how much output has changed, and ignore any changes in the price of that output, you want to look at Real GDP.

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Weight

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The importance attached to an item within a group of items.

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Base year

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The year chosen for the weights in a fixed-weight procedure.

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Fixed-weight procedure

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Uses weights from a given base year.

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Chain-weighted procedure

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Uses a geometric average of base years which change over time as the weight.

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Problems of fixed weights

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The use of fixed price weights to estimate real GDP leads to problems because it ignores: Structural changes in the economy. Supply shifts, which cause large decreases in price and large increases in quantity supplied. The substitution effect of price increases.

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Calculating the GDP deflator

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The GDP deflator is one measure of the overall price level (CPI and PPI are other price level measures). The GDP deflator is computed by the Bureau of Economic Analysis (BEA) and tells us how prices for all final goods and services ordered during a year are changing. The GDP deflator is plagued by the same problems if calculated using a fixed weight procedures as is Real GDP, so a chain-weighted procedure is used here as well.

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Underground economy

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The part of an economy in which transactions take place and in which income is generated that is unreported and therefore not counted in GDP.

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Gross National Income (GNI)

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A measure used to make international comparisons of output. GNI is GNP converted into dollars using an average of currency exchange rates over several years adjusted for rates of inflation. To make comparisons of GNP between countries, currency exchange rates must be taken into account. GNI divided by population equals gross national income per capita.

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Employed

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Any person 16 years old or older: who works for pay, either for someone else or in his or her own business for 1 or more hours per week, who works without pay for 15 or more hours per week in a family enterprise, or who has a job but has been temporarily absent, with or without pay.

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Unemployed

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A person 16 years old or older: is not working, is available for work, and has made specific efforts to find work during the previous 4 weeks.

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Not in the labor force

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A person who is not looking for work, either because he or she does not want a job or has given up looking.

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Defining & measuring unemployment

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Labor force = employed + unemployed Population over 16 = labor force + not in labor force Unemployment rate = employed/(employed + unemployed) = labor force Labor force participation rate = labor force/population over 16

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Discouraged workers

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Are people who want to work but cannot find jobs. They grow discouraged and stop looking for work, thus dropping out of the ranks of the unemployed and the labor force.

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Discouraged-worker effect

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Lowers the unemployment rate Discouraged workers are removed from both the unemployed and the labor force, lowering the percentage of the labor force unemployed.

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Frictional unemployment

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The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems.

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Structural unemployment

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The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries (normal working of the labor market; used to denote short-run job/skill matching problems). Steel companies, textile companies (once popular industries).

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Cyclical unemployment

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The increase in unemployment that occurs during recessions and depressions.

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Natural rate of unemployment

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The unemployment that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment and structural unemployment, (assuming that you're at the peak of the function).

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Costs of Unemployment

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Are neither evenly distributed across the population nor easily quantified. Unemployed often lose emergency savings, retirement savings, sometimes homes and even skills (when unemployed for long periods of time - referred to as "hysteresis") Official unemployment rate generally understates the extent of these difficulties.

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Sustained inflation

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An increase in the overall price level that continues over a significant period. A monetary policy.

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Price indexes

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Are used to measure overall price levels.

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GDP deflator

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The price index that pertains to all goods and services produced in the economy.

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Consumer price index (CPI)

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A price index computed each month by the Bureau of Labor Statistics using a bundle that is meant to represent the "market basket" purchased monthly by the typical urban consumer. The most popular fixed-weight price index. Represents a typical basic of consumer goods. Includes imports.

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Producer price indexes (PPI)

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Measure price changes for products at all stages in the production process. Three main categories are: finished goods. intermediate materials, and crude materials.

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Costs of inflation

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Rising prices is an erosion of the value of a domestic currency - this reduces money as a store of value. To the extent that prices don't all rise at the same rate, some consumers/businesses are hit harder than others - this redistributes income in an arbitrary fashion. Not all incomes keep up with inflation - some incomes for instance are fixed and don't rise with inflation (welfare), which also redistributes income in an unintended way.

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Unanticipated inflation

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An inflation that takes people by surprise - can hurt creditors. Inflation that is higher than expected benefits debtors (positive); inflation that is lower than expected benefits creditors (deflation).

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Real interest rate

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The difference between the interest rate on a load and the inflation rate.

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Costs of Deflation

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If inflation is a problem, deflation (price declines) mist be good, right? Countries with deflation have had significant problems getting their economies going again. One reason for this is that monetary policymakers can't lower interest rates below zero. Encourages consumers to put off purchases - waiting for prices to get even better. This prolongs the recession. Also redistributes income, as does inflation - deflation hurts borrowers.

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Increase output

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Add more workers. Add more machines. Increase the length of the workweek. Increase the quality of the workers. Increase the quality of the machines.

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Labor productivity

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Output per worker hour. As long as the economy and the capital stock are expanding rapidly enough, new entrants into the labor force do not displace other workers.

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Capital per worker

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Part of the reason for the upward trend in productivity is an increase in the amount of capital per worker. The other reason productivity has increased is that the quality of labor and capital has been increasing.

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Labor demand curve

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Number of workers that the firms want to hire at each wage rate.

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Labor supply curve

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Number of workers that want to work at each wage rate.

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Aggregate income

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The total income received by all factors of production in a given period.

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Aggregate output (income) (Y)

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A combined term used to remind you of the exact equality between aggregate output and aggregate income.

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Real output (or identically real GDP)

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The quantities of goods and services produced, not the dollars in circulation.

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Saving (S)

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The part of its income that a household does not consume in a given period. Distinguished form savings, which is the current stock of accumulated saving. S = Y - C (identity, or something that is always true).

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Determinants of aggregate consumption

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Household income. Household wealth. Interest rates. Households' expectations about the future. In the General Theory, Keynes argued that household consumption is directly related to its income.

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Consumption function

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The relationship between consumption and income. For an individual household, the consumption function shows the level of consumption at each level of household income. C = a + bYd C = a + b(Y - T) A --> autonomous b --> MPC Y --> consumption

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Marginal propensity to consume (MPC)

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The slope of the consumption function, or the fraction of a change in income that is consumed, or spent. 0 < b < 1

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Marginal propensity to save (MPS)

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The fraction of a change in income that is saved. MPC + MPS = 1 (identity) Once we know how much consumption will result from a given level of income, we know how much saving there will be. Therefore, S = Y - C (identity)

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Unplanned/unintentional investment

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Refers to purchases by firms of new buildings and equipment and additions to inventories, all of which add to firms' capital stock. One component of investment - inventory change - is partly determined by how much households decide to buy, which is not under the complete control of firms. Change in inventory = production - sales

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Desired/planned investment

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Refers to the additions to the capital stock and inventory that are planned by firms. For now, we will assume that planned investment is fixed. It does not change when income changes.

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Actual investment

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The actual amount of investment that takes place; it includes items such as unplanned changes in inventories.

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Autonomous variable

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When a variable, such as planned investment, is assumed not to depend on the state of the economy. It does not change when the economy changes.

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Planned aggregate expenditure

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The total amount the economy plans to spend in a given period. It is equal to consumption plus planned investment. AE = C + I + G (identity)

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Equilibrium aggregate output (income) equations

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Identities: Aggregate output = Y Planned aggregate expenditure = AE = C + I Equilibrium: Y = AE, or Y = C + I + G

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Y > C + I

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Aggregate output > planned aggregate expenditure Inventory investment > planned investment Actual investment > planned investment

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C + I < Y

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Planned aggregate expenditure > aggregate output Inventory investment < planned investment Actual investment < planned investment

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Saving/Investment approach to equilibrium

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If planned investment is exactly equal to saving, then planned aggregate expenditure is exactly equal to aggregate output, and there is equilibrium. Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment. (S = I)

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Equilibrium characteristics

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In our simple economy (households, businesses, and government), the following things are true: Y = C + I + G S + T = I + G Unplanned inventory change = 0 AE line intersects the 45 degree line.

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Multiplier

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The ratio of the change in the equilibrium level of output to a change in some autonomous variable. The multiplier of an autonomous investment describes the impact of an initial increase in planned investment on production, income, consumption spending, and equilibrium income. The size of the multiplier depends on the slope of the planned aggregate expenditure line. 1/MPS OR 1/(1 - MPC)

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MPS

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Change in S / Change in Y OR Change in I / Change in Y S = I Change in Y = Change in I x (1/MPS)

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The Paradox of Thrift

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When households become concerned about the future and decide to save more, the corresponding decrease in conniption leads to a drop in spending and income. Households end up consuming less, but they have not saved anymore.

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Discretionary fiscal policy

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Refers to deliberate changes in taxes or spending, (intentionally trying to do so to stabilize economy). The government can not control certain aspects of the economy related to fiscal policy.

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Net taxes (T)

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Are taxes paid by firms and households to the government minus transfer payments made to households by the government.

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Disposable/after-tax income (Yd)

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Equals total income minus taxes. Yd = Y - T (identity)

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Yd

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Identities: Yd = Y - T Yd = C + S Y - T = C + S Y = C + S + T

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Budget deficit

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The difference between what the government spends (G) and what it collects in taxes (T) in a given period: G - T If G exceeds T, government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government.

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Leakages/injections approach

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Taxes (T) area a leakage from the flow of income. Saving (S) is also a leakage. In equilibrium, aggregate output (income) (Y) equals planned aggregate expenditure (AE), and leakages (S + T) must equal planned injections (I + G). Algebraically, Identities: AE = C + I + G Y = C + S + T C + (S + T) = C + (I + G) S + T = I + G

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Government spending multiplier

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The ratio of the change in the equilibrium level of output to a change in government spending 1/MPS = 1/(1-MPC)

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Tax multiplier

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Change in Y = (initial increase in aggregate expenditure) x (1/MPS) Change in Y = (- Change in T x MPC)x(1/MPS) = -T x (MPC/MPS) Tax multiplier = -(MPC/MPS)

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Balanced-budget multiplier

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The ratio of change in the equilibrium level of output to a change in government spending where the change in government spending is balanced by a change in taxes so as not to create any deficit.

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Federal budget

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The budget of the federal government. The difference between the federal governments receipts and its expenditures is the federal surplus (+) or deficit (-).

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Federal debt

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The total amount owed by the federal government. The debt is the sum of all accumulated deficits minus surpluses over time.

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Privately held federal debt

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Some of the federal debt held by the U.S. government itself and some by private individuals. The private (non-government-owned) portion of the federal debt.

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Automatic stabilizers

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Are revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP. The automatic reduction in taxes (on income, profits) and increased transfer payments (unemployment payments) help offset an economic decline - thereby helping stabilize the economy. These things also increase the government deficit in bad times.

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Fiscal drag

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The negative effect on the economy that occurs when average tax rates increase because taxpayers have moved into higher income brackets during an expansion.

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Full-employment budget

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What the federal budget would be if the economy were producing at a full-employment level of output.

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Cyclical deficit

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The deficit that occurs because of a downturn in the business cycle.

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Structural deficit

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The deficit that remains at full employment.

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Money

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Anything that is generally accepted as a medium of exchange. Money is not income, and money is not wealth. Money is: a means of payment, or medium of exchange a store of value, and a unit of account. Easily portable, and easily exchanged for goods at all times.

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Barter

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The direct exchange of goods and services for other goods and services.

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Double coincidence of wants

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A barter system requires this for trade to take place. Money eliminates this problem.

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Medium of exchange, or means of payment

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Money is generally accepted by buyers and sellers as payment for goods and services.

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Store of value

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Money serves as an asset that can be used to transport purchasing power fro one time period to another.

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Unit of account

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Money is a standard that provides a consistent way of quoting prices.

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Liquidity property of money

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Makes money a good medium of exchange as well as a store of value.

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Commodity monies

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Are items used as money that also have intrinsic values in some other use. Gold is one form.

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Fiat/token

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Money is money that is intrinsically worthless.

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Legal tender

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Money that government has required to be accepted in settlement of debts.

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Currency debasement

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The decrease in the value of money that occurs when its supply is increased rapidly.

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M1/transactions money

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Money that can be directly used for transactions. M1 = currency held outside banks + demand deposits + traveler's checks + other checkable deposits A stock measure - it is measured at a point in time - on a specific day.

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M2/broad money

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Includes near monies, or close substitutes for transactions money. M2 = M1 + savings accounts + money market accounts + other near monies Main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

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Financial intermediaries

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Are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.

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Run

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On a modern-day bank occurs when many people present their claims at the same time. Fractional reserve system.

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Modern Banking System

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A brief review of accounting: Assets - liabilities = net worth, or Assets = liabilities + net worth A bank's most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the Fed. A bank's liabilities are its debts = what it owes. Deposits are debts owed to the bank's depositors.

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Assets

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Loans; cash on hand and deposits

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Liabilities

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Debts - what it owes

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Federal Reserve System (the Fed)

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The central bank of the United States.

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Reserves

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Are the deposits that a bank has at the Federal Reserve bank plus its cash on hand.

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Required reserve ratio

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The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve. Establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create. If the Fed wants to increase the money supply, the Fed can decrease the required reserve ratio, which allows the bank to create more deposits by making loans.

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Creation of money

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Excess reserves = actual reserves - required reserves

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Money multiplier

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The multiple by which deposits can increase for every dollar increase in reserves. 1 / Required reserve ratio Actual reserves x money multiplier = deposits created in the banking system

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Federal Open Market Committee (FOMC)

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Sets goals regarding the money supply and interest rates and directs the operations of the Open Market Desk in New York.

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Open Market Desk

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An office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed.

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Functions of the Federal Reserve

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Clearing interbank payments. Regulating the banking system. Assisting banks in a difficult financial position. Managing exchange rates and the nation's foreign exchange reserves. Control of mergers between banks. Examination of banks to ensure that they are financially sound. Setting of reserve requirements for all financial institutions. Lender of last resort.

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Lender of last resort

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The Fed provides funds to troubled banks that cannot find any other sources of funds. (role to keep the banking system healthy)

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How the Federal Reserve controls the money supply

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Three tools: changing the required reserve ratio; changing the discount ratio; and engaging in open market operations.

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Discount rate

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The interest rate that banks pay to the Fed to borrow from it. Bank borrowing from the Fed leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will have to do.

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Moral suasion

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The pressure that was exerted in the past by the Fed on member banks to discourage them from borrowing heavily.

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Open market operations (OMO)

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The purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply. By far the most significant tool of the Fed for controlling the money supply. The Fed's preferred means of controlling the money supply because: they can be used with some precision, are extremely flexible, and are fairly predictable. Through it, the Fed can have the money supply be whatever it wants.

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OMO purchase of securities

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Results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

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OMO sale of securities

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Results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

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Interest rate

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The price of borrowing or holding money. Thereby established by the intersection of supply and demand of money.

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Demand for money

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How much of your financial assets you want to hold in the form of money, which does not earn interest, versus how much you want to hold in interest-bearing securities, such as bonds. We are NOT talking about wanting to be more wealthy than you already are, rather it is purely a matter of how much of your current wealth you hold in the form of money (cash, checking accounts).

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Transaction Motive

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Trade-off between the liquidity of money and the interest income offered by other kinds of assets. The main reason that people hold money - to buy things.

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Nonsychronization of income and spending

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The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.

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Optimal balance

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There is an inverse relationship between money demand and interest rates.

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Speculation motive

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Also brings us to the same conclusions. Because the market value (price) of interest-bearing bonds is inversely related to the interest rate, investors may wish to hold bonds when interest rates are high with the hope of selling them when interest rates fall. When interest rates are high (low) and expected to fall (rise), demand for bonds is likely to be high (low) thus money demand is likely to be low (high). High iR --> want to hold bonds. Low iR --> want to hold money.

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Total demand for money

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The total quantity of money demanded in the economy is the sum of the demand for checking account balances and cash by both households and firms. Depends on the opportunity cost of holding money, a cost determined by the interest rate. A higher interest rate raises the opportunity cost of holding money and thus reduces the quantity of money demanded. Depends on the total dollar volume of transactions made.

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Total dollar volume of transactions

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Depends on the total number of transactions, and the average transaction amount. When output (income) rises, the total number of transactions rises, and the demand for money curve shifts to the right. When the price level rises, the average dollar amount of each transaction rises; thus, the quantity of money needed to engage in transactions rises, and the demand for money curve shifts to the right.

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Determinants of money demand

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1. Interest rate: r (negative effect causes downward-sloping money demand). 2. The dollar volume of transactions (positive effect: money demand shifts right when Y increases). --> a. Aggregate output (income): Y (positive effect: money demand shifts right when Y increases). --> b. The price level: P (positive-effect: money demand shifts right when P increases).

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Equilibrium interest rate

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The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. An increase in the supply of money lowers the interest rate.

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Increases in Y and shifts in the money demand curve

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An increase in aggregate output (income) shifts the money demand curve, which raises the equilibrium interest rate. An increase in the price level has the same effect.

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Tight monetary policy

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Refers to Fed policies the that contract the money supply in an effort to restrain the economy.

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Easy monetary policy

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Refers to Fed policies that expand the money supply in an effort to stimulate the economy.

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Goods market

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The market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined. Y = C + I + G (determines Y) Money demand depends on Y.

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Link between goods market and money market

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When r changes in the money market, this change will have an impact in the foods market, and when Y changes in the goods market, this will have an impact into money market. Money demand depends on income and planned investment depends on the interest rate.

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Link 1: Income and demand for money

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Income, which is determined in the goods market, has considerable influence on the demand for money in the money market, and consequently on interest rates. Changes in aggregate output (income), which take place in the goods market, shift the money demand curve and cause changes in the interest rate. Y inc. --> Md inc. --> r inc.

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Link 2: Planned investment and interest rate

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The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market. A more realistic assumption regarding the determination of investment spending than our earlier assumption that investment spending was autonomous.

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Expansionary fiscal policy

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Either an increase in government spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y).

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Expansionary monetary policy

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An increase in the money supply aimed at increasing aggregate output (income (Y).

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Crowding-out effect

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The tendency for increases in government spending to cause reductions in private investment spending. G inc. --> Y inc. --> Md inc. --> r inc --> I dec.

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Sensitivity or insensitivity of planned investment

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Crowding-out effect depends on this spending to changes in the interest rate. Interest sensitivity means that planned investment spending changes a great deal in response to changes in the interest rate.

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Expansionary monetary policy (increase)

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An increase in the money supply decreases the interest rate and increases investment and income. However, the simultaneous increase in the demand for money keeps the interest rate from falling as far as it otherwise would. Ms inc. --> r dec. --> I inc. --> Y inc. --> Md inc.

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Expansionary fiscal policy (increase)

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An expansionary fiscal policy (higher government spending or lower taxes) will increase aggregate output (income). If the money supply were unchanged following an increase in the demand for money, the interest rate would rise and there would be crowding out. But if the Fed were to "accommodate" the fiscal expansion (by increasing the money supply(, the interest rate would not rise.

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Contractionary fiscal policy

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Refers to a decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y). G dec. or T inc. --> Y dec. The decrease in Y is smaller when we take the money market into account.

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Contractionary monetary policy

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Refers to a decrease in the money supply aimed at decreasing aggregate output (income) (Y). When we take into account the money market, the interest rate will increase by less, and the decrease in Y will be smaller.

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Other determinants of planned investment

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The interest rate. Expectations of future sales. Capital utilization rates. Relative capital and labor costs.

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Aggregate demand

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The total demand for goods and services in the economy. To derive the curve, we examine what happens to aggregate output (income) (Y) when the price level (P) changes assuming no changes in government spending (G), net taxes (T), or the monetary policy variable (Ms).

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Aggregate demand (AD) curve

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A curve that shows the negative relationship between aggregate output (income) and the price level. At all the points along the AD curve, both the goods market and the money market are in equilibrium.

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The consumption link

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The decrease in consumption brought about by an increase in the interest rate contributes to the overall decrease in output. C dec. --> iR inc. --> Y dec.

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The real wealth effect/real balance effect

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The change in consumption brought about by a change in real wealth that results from a change in the price level.

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Aggregate supply

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The total supply of all goods and service in the economy.

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Aggregate supply (AS) curve

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A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level.

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Aggregate supply in the short run

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The aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical. When the economy is operating at low levels of output, an increase in aggregate demand is likely to result in an increase in output with little or no increase in the overall price level. As the economy approaches maximum capacity, firms respond to further increase in demand only by raising prices.

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Cost shock/supply shock

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A change in costs that shifts the aggregate supply (AS) curve.

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Shift (increase) of the short-run aggregate supply curve

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Lower costs. Lower input prices. Lower wage rates. Economic growth. More capital. More labor. Technological change. Public policy. Supply-side policies. Tax cuts. Deregulation. Good weather.

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Shift (decrease) of the short-run

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Higher costs. Higher input prices. Higher wages rates. Stagnation. Capital deterioration. Public policy. Waste and inefficiency. Over-regulation. Bad weather, natural disasters, destruction from wars.

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Classical view of the labor market

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The quantity of labor demanded and supplied are brought into equilibrium by rising and failing wage rates. There should be no persistent unemployment about the frictional and structural amount.

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Labor supply curve

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Illustrates the amount of labor that households want to supply at each given wage rate.

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Classical labor market and the aggregate supply curve

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Classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. This means that the AS curve is vertical. When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy.

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Sticky wages

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Refers to the downward rigidity of wages as an explanation for the existence of unemployment.

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Social/implicit contracts

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One explanation for downwardly sticky wages is that firms enter into social, or implicit contracts. These contracts are unspoken agreements between workers and firms that firms will not cut wages.

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Relative-wage explanation of unemployment

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Holds that workers are concerned about their wages relative to the wages other workers in other firms and industries.

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Explicit contracts

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Are employment contracts that stipulate workers' wages, usually for a period of one to three years. Wages set in this way do not fluctuate with economic conditions.

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Cost of living adjustments (COLAs)

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Are contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the mores wages are raised.

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Efficiency wage theory

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An explanation for unemployment that holds that the productivity of workers increased with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate.

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Imperfect information

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They may simply set wages wrong - wages that do not clear the labor market.

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Minimum wage laws

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Set a floor for wage rates, and explain at least a fraction of unemployment.

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Short-run relationship between the unemployment rate and inflation

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In the short-run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related. Y inc. --> E inc. --> U dec. As depicted by the short run AS curve, the relationship between Y and the price level (P) is positive. The relationship between U and P is negative. As U declines in response to the economy moving closer and closer to capacity output, the overall price level rises more and more.

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Inflation rate

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The percentage change in the price level.

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Phillips Curve

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Shows the relationship between the inflation rate and the unemployment rate.

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Short-run phillips curve

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There is a trade-off between inflation and unemployment. To lower the inflation rate, we must accept a higher unemployment rate.

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Aggregate supply, aggregate demand analysis & the phillips curve

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Not consistent w/SRPC: When AS shifts with no shifts in AD, there is a negative relationship between P and Y. Consistent w/SRPC: When AD shifts with no shifts in AS, there is a positive relationship between P and Y. If both AD and As are shifting, there is no systematic relationship between P and Y and thus no systematic relationship between the unemployment rate and the inflation rate.

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Role of import prices

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The AS curve shifts when input prices change, and input prices are affected by the price of imports.

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Expectations and the phillips curve

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Expectations are self-fulfilling. This means that wage inflation is affected by expectations of future price inflation. Price expectations that affect wage contracts eventually affect prices themselves. Inflationary expectations shift the Phillips curve to the right. Inflationary expectations were stable in the 1950s and 1960s, but increased in the 1970s.

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Long-run AS curve, potential GDP, & the natural rate of unemployment

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When output is pushed above potential GDP (Y), there is upward pressure on costs. Rising costs push the short-run AS curve to the left. The quantity supplied will end up back at Y. If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemployment.

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Natural rate of unemployment (U*)

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The unemployment rate that is consistent with the notion of a fixed long-run output at potential GDP.

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The NAIRU - the non accelerating inflation rate of unemployment

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Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate). To the left of the NAIRU the inflation rate is accelerating. To the right of the NAIRU the inflation rate is decelerating. A favorable shift of the PP curve is to the left because the PP curve crosses zero at a lower rate of unemployment. A possible recent source of favorable shifts is increased foreign competition, which may have kept both wage costs and other input costs down.

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Shifts of the short run phillips curve (SRPC) and the PP curve

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Events that shift the short run aggregate supply curve (SRAS) will shift the SRPC and the PP curves in the opposite direction. Increased input prices shifts the SRAS curve to the left, and therefore shift the SRPC and the PPC curve to the right. Increased inflationary expectations shift the short run AS curve to the left and the SRPC and PP curve to the right. Increased foreign competition, which can drive down input prices shifts the SRAS curve to the right and the SRPC and PP curve to the left.

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Businesses can obtain money in three ways

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Borrow form a bank (bank loan), Issue debt to the public (bond issuance) or Issue shares of ownership (equity issuance).

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Stock

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A certificate that certifies ownership of a certain portion of a firm. A capital gain is an increase in the value of an asset. A realized capital gain is an increase in the value of an asset. A realized capital gain is the gain that occurs when the owner of an asset actually sells the asset for more than he or she paid for it.

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Stock prices

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Are affected by people's expectations of future profits, the larger the current stock price. The timing and risk associated with those future profits also impact the stock price, thus a stock is valued by measuring the discounted risk adjusted future earnings of the company. Stock prices may also depend on what people expect others will pay for the stock in the future, bringing about the possibility of stock market "bubbles".

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Dow Jones Industrial Average

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An index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance.

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NASDAQ Composite

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An index based on the stock prices of over 5,000 companies traded on the NASDAQ stock market (national Association of Securities Dealers Automatic Quotation System).

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Standard and Poor's 500 (S&P 500)

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An index based on the stock prices of 500 of the largest firms by market value.

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Household wealth effects on the economy

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An increase in wealth increases consumer spending. Fluctuations in household wealth are frequently due to fluctuation in stock prices and housing prices. Unpredictable wealth changes bring unpredictable consumption changes - and thus unpredictable changes in GDP. In a financial criss, macroeconomic problems caused by the wealth effect of a stock or housing market crash worsen.

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Stabilization policy

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Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible.

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Time lags

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Are delays in the economy's response to stabilization policies. Lags present a major problem when trying to implement monetary and fiscal policy.

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Stabilization: "the fool in the shower"

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Attempts to stabilize the economy can prove destabilizing because of time lags. Milton Friedman likened these attempts to a "fool in the shower." The government is constantly stimulating or contracting the economy at the wrong time.

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Recognition lag

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Refers to the time it takes for policy makers to recognize the existence of a boom or a slump. One definition of a recession, is two consecutive quarters of negative growth.

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Implementation lag

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The time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. The implementation lag for a monetary policy is generally much shorter than for fiscal policy.

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Response lag

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The time it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself. Most of the effects from changes in government spending occurs more rapidly than does net taxes or monetary policy effects. Though even some of government spending effects are delayed. The delay in the multiplier of government spending occurs because neither individuals nor firms revise their spending plans instantaneously.

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Gramm-Rudman-Hollings Bill

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Passed by the U.S. Congress and signed by President Reagan in 1986, is a law that set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991. In practice, those targets never came close to being achieved.

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Effects of spending cuts on the deficit

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A cut in government spending causes the economy to contract. Economic contraction causes both the taxable income of households and the profits of firms fall. In fact, in general the deficit tends to rise when GDP falls, and tends to fall when GDP rises.

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Deficit response index (DRI)

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The amount by which the deficit changes with a $1 change in GDP. If the DRI equals -.22, for example, the deficit rises by $0.22 billion for each $1 billion decrease in GDP. Implication: Spending cuts must be larger than the deficit reduction we wish to achieve.

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Negative demand shock

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Something that causes a negative shift in consumption or investment schedules or that leads to a decrease in U.S. exports. The severity of the negative impact of such an event is mitigated by allowing the deficit to worsen. A larger budget deficit cushions the blow to the rest of the economy.

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Automatic destabilizers

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Refer to revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to destabilize GDP. Any balanced budget amendment that cuts expenditures when revenues decline WORSENS an economic downturn.

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Economic growth

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Refers to an increase in the total output of an economy - generally defined as an increase of real GDP per capita.

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Modern economic growth

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The period of rapid and sustained increase in real output per capita that began in the Western World with the Industrial Revolution.

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Production possibility frontier (PPF)

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Shows all the combinations of output that can be produced if all society's scarce resources are fully and efficiently employed. Economic growth expands society's production possibilities shifting the ppf up and to the right.

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Aggregate production function

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The mathematical representation of the relationship between inputs and national output, or gross domestic product. If you think of GDP as a function of both labor and capital, you can see that an increase in GDP can come about through: An increase in the labor supply. An increase in physical or human capital. An increase in productivity (the amount of product produced by each unit of capital or labor).

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Increase in labor supply

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An increasing labor supply can generate more output, but if the capital stock remains fixed, the new labor will be less productive (diminishing returns). Growth in the labor force, without a corresponding increase in the capital stock or technological change, might lead to growth of output but declining productivity and a lower standard of living.

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Increases in physical capital

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The increase in capital stock is the difference between gross investment and depreciation.

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Increases in productivity

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Growth that cannot be explained by increases in the quantity of inputs can be explained only by an increase in the productivity of those inputs.

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Productivity of an input

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The amount produced per unit of an input. Factors that affect the productivity of an input include technological change, other advances in knowledge, and economies of scale. Technological changes affects productivity in two stages: First there is an advance in knowledge, or an invention. Then there is innovation, or the use of new knowledge to produce a new product or to produce an existing product more efficiently. There are capital-saving innovations, and labor-saving innovations.

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Limitations to growth

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Failure to enforce the rule of law property rights, court system, press, corruption, issues. Wars and Revolutions Poor public education and health Low saving and investments Best and brightest leave - brain drain.

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Policies for faster growth

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Stimulate saving Stimulate research and development Improve the quality of education Improve health Encourage international trade.

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Keynesian economics

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The foundation of all macroeconomics. Sometimes refers to economists who advocate government intervention in the economy.

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Monetarism

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Main message - "money matters".

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Velocity of Money

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The number of times a dollar bills changes hands, on average, during a year; the ratio of nominal GDP to the stock of money. Identity: V = GDP/M We can expend this definition slightly by noting that nominal income (GDP) is equal to real output (income) (Y) times the overall price level (P). Identities: GDP = P x Y V = (P x Y)/M M x V = P x Y

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Quantity theory of money

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Based on the identity M x V = P x Y and the assumption that the velocity of money is constant (or virtually constant). The key assumption is that the velocity of money is constant (or nearly so) over time. If we let V denote the constant value of V, the equation for the quantity theory can be written as follows: M x V = P x Y Strict monetarists would also argue that Y is unaffected by changes in M. The implication: changes in M only bring about changes in P. In other words, inflation is always and solely a monetary phenomenon.

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Keynesian/Monetarist debate

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Monetarists are skeptical of the Fed's ability to "manage" the economy - to expand the money supply during bad times and contract it during good times. The leading spokesman for monetarism, Milton Friedman, advocated a policy of steady and slow money growth - specifically, that the money supply should grow at a rate equal to the average growth of real output (income) UY). While not all Keynesians advocate an activist federal government, many advocate the application of coordinated monetary and fiscal policy tools to reduce instability in the economy - to fight inflation and unemployment. The debate between Keynesians and monetarists subsided with the advent of what we call "new classical macroeconomics".

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Supply-side economics

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In the late 1970s and early 1980s, supply-siders argued that the real problem with economy was not demand, but high rates of taxation and heavy regulation that reduced the incentive to work, to save, to invest. What was needed was not a demand stimulus, but better incentives to stimulate supply. At their most extreme, supply-siders argued that the incentive effects of supply-side policies were likely to be so great that a major cut in tax rates would actually increase tax revenues. Even though tax rates would be lower, more people would be working and earning income and firms would earn more profits, so that the increases in the tax bases (profits, sales, and income) would then outweigh the decreases in rates, resulting in increased government revenues.

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Laffer curve

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Shows that the amount of revenue and government collects is a function of the tax rate. It shows that when tax rates are very high, an increase in the tax rate would cause tax revenues to fall. Similarly, under the same circumstances, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise. With the tax rate measured on the vertical axis and tax revenue measured on the horizontal axis, the Laffer curve shows that there is some tax rate beyond which the supply response is large enough to lead to a decrease in tax revenue for further increases in the tax rate.

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Evaluating supply-side economics

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Criticisms of supply-side economics - unlikely a tax cut would substantially increase the supply of labor. In theory, a tax cut could even lead to a reduction in labor supply. Traditional theory suggests that a huge tax cut will lead to an increase in disposable income and, in turn, an increase in consumption spending (a component of aggregate expenditure). Although an increase in planned investment (brought about by a lower interest rate) leads to added productive capacity and added supply in the long run, it also increases expenditures on capital goods (new plant and equipment investment) in the short run.

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Rational-expectations hypothesis

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The hypothesis that people know the "true model" of the economy and that they use this model to form their expectations of the future.

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Rational expectations and market clearing

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If firms have rational expectations and if they set prices and wages on this basis, disequilibrium in any market is only temporary. In this world, all markets clear (on average) and there is a full employment thus no need for government stabilization policies.

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Lucas supply function

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The supply function embodies the idea that output (Y) depends on the difference between the actual price level and the expected price level.. Y = f(P - Pe)

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Price surprise

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Actual price level minus expected price level.

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Policy implication of the lucas supply function

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In combination with the assumption that expectations are implies that anticipated policy changes have no effect on real output. The general conclusion is that any announced policy change - in fiscal policy or any other policy - has no effect on real output because the policy change affects both actual and expected price levels in the same way. Rational-expectations theory combined with the Lucas supply function proposes a very small role for government policy in the economy.

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Real business cycle theory

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An attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to technology and other shocks.

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New Keynesian economics

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A field in which models are developed under the assumptions of rational expectations and sticky prices and wages.

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Evaluating the rational expectations assumption

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When expectations are not rational, there are likely to be unexploited profit opportunities, and most economists believe such opportunities are rare and short-lived. The argument against rational expectations is that it requires households and firms to know too much while the gain from learning the true model (or a good approximation of it) may not be worth the cost. Although the assumption that expectations are rational seems consistent with the satisfaction-maximizing, and profit-maximizing postulates of microeconomics, such an assumption is more extreme and demanding because it requires more information on the part of households and firms.

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Trade surplus

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When a country exports more than it imports.

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Trade deficit

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The situation when a country imports more than it exports.

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Corn Laws

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The tariffs, subsidies, and restrictions enacted by the British Parliament in the early nineteenth century to discourage imports and encourage exports of grain.

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Theory of comparison

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David Ricardo's. Used to argue against the corn laws, states the specialization and free trade will benefit all trading partners (real wages will rise), even those that may be absolutely less efficient producers.

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Absolute advantage

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A country enjoys absolute advantage over another country in the production of a product when it uses fewer resources to produces that products than the other country does.

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Comparative advantage

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A country enjoys comparative advantage in the production of a good when that good can be produced at a lower cost in terms of other goods.

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Gains from comparative advantage

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Even if a country had a considerable absolute advantage in the production of both goods, Ricardo would argue that specialization and trade are still mutually beneficial. When countries specialize in producing the goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently.

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Terms of trade

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The ratio at which a country can trade domestic products for imported products. Determines how the gains from trade are distributed among trading partners. When trade is free - unimpeded by government-instituted barriers - patterns of trade and trade flows result from the independent decisions of thousands of importers and exports and million of private households and firms.

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Exchange rates

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The ratio at which two currencies are traded, or the price of one currency in terms of another. For any pair of countries, there is a range of exchange rates that can lead automatically to both countries realizing the gains from specialization and comparative advantage.

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Factor endowments

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Refer to the quantity and quality of labor, land, and natural resources of a country. Seem to explain a significant portion of actual world trade patterns.

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Heckscher-Ohlin theorem

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A theory that explains the existence of a country's comparative advantage by its factor endowments. According to the theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

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Product differentiation

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A natural response to diverse preferences within an economy, and across economies.

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Economies of scale

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May be available when producing for a world market that would not be available when producing for a limited domestic market.

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Protection

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The practice of shielding a sector of the economy from foreign competition.

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Tariff

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A tax on imports.

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Quota

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A limit on the quantity of imports.

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Export subsidies

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Are government payments made to domestic firms to encourage exports.

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Dumping

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Refers to a firm or industry that sells products on the world market at prices below the cost of production.

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Smoot-Hawley tariff

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The U.S. tariff law of the 1930s, which set the highest tariff in U.S. history (60 percent). It set off an international trade war and caused the decline in trade that is often considered a cause of the worldwide depression of the 1930s.

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General agreement on tariffs and trade (GATT)

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An international agreement signed by the United States and 22 other countries in 1947 to promote the liberalization of foreign trade.

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World Trade Organization (WTO)

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Replaced GATT as the forum to discuss and attempt to resolve trade related issues between countries in 1995. The WTO has 153 members and 30 observers which together represent almost all international trade

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Economic integration

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Occurs when two or more nations join to form a free-trade zone.

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U.S.-Canadian free trade agreement

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An agreement in which the United States and Canada agreed to eliminate all barriers to trade between the two countries by 1988.

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North American free-trade agreement (NAFTA)

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An agreement signed by the United States, Mexico, and Canada in which the three countries agreed to establish all of North America as a free-trade zone.

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The case for free trade

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Based on the theory of comparative advantage. When countries specialize and trade based on comparative advantage, consumers pat less and consume more, and resources ares used more efficiently. When tariffs and quotas are imposed, some of the gains from trade are lost.

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The case for protection

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Protection saves jobs. Cheap foreign labor makes competition unfair. Some countries engage in unfair trade practices. Protection safeguards national security. Protection discourages dependency. Protection safeguards infant industries.

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Infant industry

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A young industry that may need temporary protection from competition from the established industries and other countries to develop and acquired comparative advantage.

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Foreign exchange

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Simply all currencies other than the domestic currency of a given country.

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Balance of payments

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The record of a country's transactions in goods, serves, and assets with the rest of the world; also the record of country's sources (supply) and uses (demand) of foreign exchange.

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Current account

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The sum of a country's: net exports (exports minus imports), net income received from investments abroad, and net transfers payments from abroad. Exports earn foreign exchange and are a credit (+) item on the current account. Imports use up foreign exchange and are a debt (-) item.

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Balance of trade

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The difference between a country's exports of goods and services and its imports of goods and services. Balance of trade = dollar price of exports x quantity of exports - dollar price of imports x quantity of imports

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Investment income

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Consists of holdings of foreign assets that yield dividends, interest, rent, and profits paid to U.S. asset holders (a source of foreign exchange). Net transfer payments are the difference between payments from the United States to foreigners and payments from foreigners to the United States.

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Balance on current account

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Consists of net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments. It shows how much a nation has spent relative to how much it has earned.

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Capital account

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For each transaction recorded in the current account, there is an offsetting transaction recording in the capital account. The capital account records the changes in assets and liabilities.

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Balance on capital account

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The sum of the following (measured in a given period): the change in private U.S. assets abroad the change in foreign private assets in the U.S. the change in U.S. government assets abroad the change in foreign government assets in the U.S. In the absence of errors, the balance on capital account would equal the negative of the balance on current account. If the capital account is positive, the change in foreign assets in the country is greater than the change in the country's assets abroad, which is a decrease in the net wealth of the country.

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Trade feedback effect

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The tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that country.

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Price feedback effect

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The process by which a domestic price increase in one country can "feed back" on itself through export and import prices. Inflation is "exportable."

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Floating/market-determined exchange rates

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Are exchange rates determined by the unregulated forces of supply and demand. Exchange rate movements have important impacts on imports, exports, and movement of capital between countries.

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Depreciate

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Fall in value.

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Appreciate

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Rise in value.

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Purchasing power parity: the law of one price

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If the costs of transportation are small, the price of the same good in different countries should be roughly the same. If the law of one price held for all goods, and if each country consumed the same market basket of goods, the exchange rate between the two currencies would be determined simply by the relative price levels in the two countries. The theory that exchange rates are set so that the price of similar goods in different countries is the same.

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Factors that affect exchange rates

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A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries, and there is a general tendency for the currencies of a relative high-inflation countries to depreciate. Higher inflation leads to weaker currency. The level of a country's interest rate relative to interest rates in other countries is another determinant of the exchange rate. If U.S. interest rates rise relative to British interest rates, British citizens may be attracted to U.S. securities. Higher domestic interest rates means stronger currency.

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Effects of exchange rates on the economy

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When a country's currency depreciates (falls in value), its import prices rise and its export prices (in foreign currencies) fall. When the U.S. dollar is cheap, U.S. products are more competitive in world markets, and foreign-made goods look expensive to U.S. citizens. A depreciation of a country's currency can serve as a stimulus: Foreign buyers are likely to increase their spending on U.S. goods U.S. buyers substitute U.S.-made goods for imports Aggregate expenditure on domestic output will rise Inventories will fall GDP (Y) will increase.

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Exchange rates and prices

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Depreciation of a country's currency tends to increase the price level. Export demand rises. Domestic buyers substitute domestic products for the now more expensive imports. If the economy is operating close to capacity, the increase in aggregate demand is likely to result in higher prices. If import prices rise, costs may rise for business firms, shifting the AS curve to the left.

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J-curve effect

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The balance of trade gets worse before it gets better following a currency depreciation. Initially, the negative effect on the price of imports may dominate the positive effects of an increase in exports and a decrease in imports. But when imports and exports have had a time to respond to price changes, the balance of trade improves.

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Monetary policy with flexible exchange rates

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Fed actions to lower interest rates result in a decrease in the demand for dollars and an increase in the supply of dollars, causing the dollar to depreciate. If the purpose of the Fed is to stimulate the economy, dollar depreciation is a good thing. It increases U.S. exports and decreases imports. Monetary policy is more effective in flexible FX regime b/c increase iR change.

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Fiscal policy with flexible exchange rates

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Flexible exchange rates may not help in the attempt by government to cut taxes in order to stimulate the economy. A tax cut results in increased household spending, but some of that spending leaks out as imports, reducing the multiplier. This is also true of increases in government spending. As income increases, the demand for money increases. The resulting higher interest rates cause the dollar to appreciate. Exports fall, imports rise, again reducing the multiplier. If interest rates rise, private investment may be crowded out, also lowering the multiplier.

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Monetary policy with fixed exchange rates

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Monetary policy has no role in a country that has a fixed exchange rate. For example, an attempt to lower interest rate results in currency depreciation and a lower (not a fixed) exchange rate. In the absence of capital controls, the monetary authority loses its independence.

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The gold standard

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Early in the century, during the gold standard era, nearly all currencies were backed by gold. Their values were fixed in terms of a specific number of ounces of gold, which determined their values in international trading - exchange rates. The debate over whether the gold standard is a sound economic policy, has been going on for a LONG time.

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"Pure" fixed exchange rates

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Under this type of system, governments set a particular fixed rate at which their currencies will exchange for each other. There is no automata mechanism to keep exchange rates aligned with each other, as with the gold standard. Therefore, governments must at times intervene to keep currencies aligned at their established values.

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Bretton Woods system

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At the end of World War II, economists from the United States and Europe met to formulate a new set of rules for exchange rate determination. Countries were to maintain fixed exchange rates with each other. All currencies were fixed in terms of the U.S. dollar. Countries experiencing a persistent current account deficit (or fundamental disequilibrium) in their balance of payments were allowed to change their exchange rates.

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Flexible system

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The alternative to a fixed exchange rate system: In a freely floating system, governments do not intervene at all in the foreign change market. In a managed floating system, governments intervene if markets are becoming disorderly.

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